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Dollar's Strength Tied to Economy, Not Fed

The U.S. dollar may lurch higher on Wednesday if the Federal Reserve signals an end to its campaign of slashing interest rates, but a rally would soon fizzle if April's jobs report comes in well below forecasts.

The dollar has appreciated in recent days on expectations that the Fed, in its statement after a two-day policy meeting, may suggest it is ready to stop cutting rates for now.

Exchanging Dollars and Euros
Exchanging Dollars and Euros

Since mid-September, the central bank has reduced overnight lending rates by 3 percentage points to 2.25 percent, and it is seen trimming another quarter point on Wednesday.

The Fed's aggressive stance, aimed largely at stabilizing financial markets in the wake of the subprime mortgage crisis, has undermined the appeal of dollar-denominated assets to foreign investors who could find higher yields elsewhere.

That drove the greenback to historic lows against the euro.

But even if the Fed were to signal a pause, any gains for the dollar would depend on April's nonfarm payrolls report due Friday.

If the data falls well below forecast, investors may begin to bet the Fed may have to resume rate cuts to assure adequate economic growth.

"We might see additional dollar buying on the statement if it does suggest a kind of pause, but I suspect it won't last longer.

There will be some dollar buying on the news," said David Gilmore, partner at FX Analytics in Essex, Connecticut.

The dollar's decline has pushed oil and gold prices to record highs as investors scramble to hedge against a weakened greenback and the resulting inflation.

It has, however, boosted U.S. exports, helping reduce the country's huge current account gap.

With some economic data coming in slightly above forecasts and financial markets showing signs of stability, analysts expect the Fed's policy-making Federal Open Market Committee (FOMC) to cut the overnight lending rate by a scant 25 basis points Wednesday.

"The FOMC has done most of its work. If the market feels that we are now at the end of the U.S. rate-cutting cycle, that clearly is going to help the dollar," said Boris Schlossberg, senior currency strategist at DailyFX.com in New York.

The dollar's unprecedented decline, particularly against the euro, has reflected a narrowing differential between U.S. rates and the euro zone's benchmark, which has held at 4 percent.

The better-than-expected economic data have led some analysts to believe that the United States would probably slip into recession and quickly recover, a situation referred to as a V-shaped recession recovery.

"People are pricing a V-shaped recovery. I don't know on what basis. I think by Friday we will see reaffirmation of the weakness of the U.S. economy and people will start thinking a U- or L-shaped recession recovery," said Gilmore.

"The assumption of the Fed being on hold is subject to quick revision," he said.

"A weak employment report on Friday, and the market is back to pricing a Fed easing in June." The payrolls report will likely show that the U.S. economy shed a net 80,000 jobs in April after eliminating a similar number in March, according to a Reuters poll.

That would mark the fourth straight month that U.S. employers have cut payrolls.

"If the data signals very, very severe deterioration, then we can have another retest back to the 1.60 level (on euro/dollar), but not beyond that," said Schlossberg.

The euro was around $1.5628 on Monday.

It touched a record peak of $1.6018 last week and has gained 7.2 percent against the dollar so far this year after a 10 percent rise in 2007.

Analysts said a pause signal from the Fed alone would not herald a turnaround for the dollar.

For that to happen, the European Central Bank would need to show it was ready to start cutting rates and the Group of Seven leading industrialized nations would have to commit to currency-market intervention.

So far, the ECB has shown little sign of moving toward a rate-cutting path any time soon, with its focus fixed on soaring inflation.

The recent G7 meeting, meanwhile, did not discuss the issue of foreign exchange intervention.

Still, some analysts are encouraged that a weak dollar is boosting exports and making small dents in the United States' huge current account deficit.

That should help the currency in the long run, though record oil prices could spoil the picture.

"I think we are closer to getting the fundamentals right, right now, but there are still a lot of hurdles to jump," said Robert Kowit, a senior portfolio manager at Federated International Bond Fund in New York.

"What is becoming apparent to most people is that U.S. rates are probably going to go higher.

Once interest rates do start to move up, there is going to be concern that will slow down any recovery that might be going on, so it would be offsetting pressures on the dollar for the intermediate term." Kowit said the dollar, considered undervalued against most of the currencies of the United States' trading partners, would probably trade around current levels versus major currencies.

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